Shortfall penalties – the carrot or the stick?

By Amy Sexton, Campbell Rose & Robyn Walker

You would have to have been living under a rock if you had not heard of, or experienced, the significant increase in Inland Revenue’s risk review and audit activities. This is due, in large part, to a funding boost in the 2024 Budget for “investment in compliance activities”. Regardless of this increase in investigation activities, New Zealand’s tax system is still based on self-assessment and voluntary compliance. For this system to work for everyone it requires taxpayers to be honest and diligent when taking tax positions. One of the ways of encouraging this honesty and diligence (and discouraging the opposite) is the shortfall penalty regime.

Shortfall penalties – what are they?

Shortfall penalties are imposed to encourage taxpayers to voluntarily comply, and to penalise those who do not. If a taxpayer pays an amount of tax that is lower than what Inland Revenue determines is owed, including by overstating a tax benefit, (a tax shortfall), that taxpayer may be charged a penalty, imposed as a percentage of the tax shortfall.

The shortfall penalty framework sets a progressive level of severity, based on the nature of the breach and culpability of the taxpayer:

To ensure the penalty is proportionate to the seriousness of the non-compliance, there are circumstances where a shortfall penalty may be reduced or eliminated, including:

• 100% reduction (in cases of not taking reasonable care or unacceptable tax position) when a full voluntary disclosure is made prior to notification of an audit
• 75% reduction (in the case of other penalties) when a full voluntary disclosure is made prior to notification of an audit
• 75% reduction if there is a “temporary shortfall” when a taxpayer has reversed or corrected a shortfall permanently (or will do so within a prescribed timeframe)
• 40% reduction when a voluntary disclosure is made post notification of an audit, but before the audit commences
• 50% reduction for taxpayers with “prior good behaviour”

Trends in shortfall penalties

Inland Revenue is required to report the shortfall penalties imposed during each financial year (ended 30 June) to the Ministers of Finance and Revenue. We have been keeping records of the trends in shortfall penalties being imposed since 2011. Since a peak in 2017, there has been a steady drop in the total number of shortfall penalties imposed, which coincided with Inland Revenue’s Business Transformation project and, from 2020, its COVID-19 pandemic response work.

While it is too early to see the real impact of Inland Revenue’s recently increased compliance funding and activity on the level of shortfall penalties imposed, from 2022 there has already been a slow increase in the overall number of shortfall penalties imposed. This trend upwards is not matched by the overall total dollar value of shortfall penalties imposed, which shows more fluctuation. Inland Revenue has explained that this fluctuation was due to penalties imposed on one taxpayer for an avoidance arrangement in 2022 – demonstrating the potentially material impact of the “abusive tax position” penalty where it is successfully applied by Inland Revenue. It is worth noting in this regard that the courts have generally upheld the imposition of shortfall penalties by Inland Revenue – but not in all cases, particularly where issues such as the capital/revenue distinction, rather than general anti-avoidance cases with “sharp” facts, are involved.

Once again, GST continues to be the tax type with the highest number of shortfall penalties imposed, while income tax remains the tax type with the highest “dollar value” of shortfall penalties imposed.

Up until 2022 the most common shortfall penalty imposed (by number) was for evasion (150%), and for actual dollar value was abusive tax position (100%). However, since 2022 there has been a noticeable change. Gross carelessness (40%) has now leapfrogged evasion to be the most commonly imposed shortfall penalty by number – it is worth noting that this penalty cannot be eliminated through a voluntary disclosure prior to notification of an audit. There has also been a noticeable increase in the number of not taking reasonable care (20%) penalties imposed. Evasion (150%) has taken over as the penalty with the overall highest dollar value – this is presumably due to Inland Revenue’s focus on the cash economy, particularly in certain sectors.

With Inland Revenue’s increased scrutiny of businesses and their tax positions, we expect the trend towards not taking reasonable care (20%) and gross carelessness (40%) penalties to continue – particularly if tax compliance processes and governance have become somewhat complacent during the COVID-19 period. What may seem at odds with this general upwards trend for shortfall penalties is the continued flat line for the unacceptable tax position (20%) penalty. However, this can be explained by the special administrative rules for this penalty, which mean that any tax shortfall must exceed the greater of $50,000 and 1% of the total tax in the return before it can be imposed; and the fact that a more detailed analysis must be undertaken by Inland Revenue in terms of establishing that the statutory and case law position is such that the relevant tax position cannot be “about as likely as not” to be correct.

How do I ensure that these penalties are not imposed

The simplest answer to ensuring that shortfall penalties are not imposed is to continue to be voluntarily compliant. Establish sound tax governance (and implement it fully, including a tax risk controls framework, and regularly ensuring it remains fit-for-purpose), get good tax advice from the start, keep accurate records, file returns on time and, if you identify any errors, tell your tax advisor and make a full and complete voluntary disclosure. We cover this in more detail in our August 2024 Tax Alert article.

What are we seeing happening in practice now

In our experience we are seeing Inland Revenue imposing virtually automatic “not taking reasonable care” penalties for errors, regardless of the nature of the error or the taxpayer. A recent example of where this shortfall penalty has been applied incorrectly is in a Technical Decision Summary published at the end of February 2025. In this case Inland Revenue’s Customer and Compliance Services (CCS) position prevailed in the disputed tax issue (a deduction from output tax for GST). However, CCS had imposed a not taking reasonable care shortfall penalty on the taxpayer. It was determined in adjudication that the taxpayer was not liable for this shortfall penalty as the taxpayer had done what a reasonable person would have done in the circumstances.

What we find concerning in this case is that the issue under dispute was described by the adjudicator as being “significant and complex” and the taxpayer obtained tax advice from an external, approved tax advisor. In our opinion, the imposition of the not taking reasonable care shortfall penalty in this instance (based on the facts described in the Technical Decision Summary) does not follow existing Inland Revenue guidance, good practice and case law. We have also seen questionable shortfall penalties imposed for very small amounts of tax shortfall, meaning in practice that taxpayers are unlikely to challenge those penalties on a cost/benefit basis.

Existing Inland Revenue guidance on shortfall penalties is 20 years old and we are happy to see that the Tax Counsel Office has on its “items currently being worked on” work programme the updating of guidance for the not taking reasonable care and unacceptable tax position penalties. Guidance for abusive tax position, evasion and gross carelessness are also on the work programme but are recorded as “not currently being worked on”. We hope that the Tax Counsel Office is able to progress all the shortfall penalties guidance documents this year.

In the meantime it is hoped that Inland Revenue’s internal consistency protocols for the imposition of shortfall penalties are being robustly and equitably applied, and that more generally an appropriate level of oversight is being applied to the decision-making of imposing these shortfall penalties (which in some cases will involve staff members new to the world of investigations and tax technical analysis).

If you have any questions about shortfall penalties, Inland Revenue investigations or voluntary disclosures please contact your usual Deloitte advisor.